The Fed could stop shrinking multitrillion-dollar balance sheet

• As a result, Fed watchers are moving up their expected timeline for when the central bank will stop shrinking its multitrillion-dollar balance sheet.

The intrigue: What happens next could amplify White House tensions with the Fed.

• Trump officials are pressuring the Fed to cut rates, but they are also deeply critical of how the Fed uses its holdings of government and mortgage bonds to influence the economy.

The big picture: Since 2022, the Fed has let these securities roll off its balance sheet — a process called quantitative tightening, a reversal of the massive bond purchases (quantitative easing) aimed at stimulating the economy during the COVID-19 pandemic era.

• There are signs the Fed has drained money from the financial system down to a level that is rattling key funding markets.

Zoom in: Quantitative tightening has been smooth so far, but "there is now a risk that things start to become somewhat bumpier," Michael Brown, a senior research strategist at Pepperstone, wrote in a note.

• Banks "have become less willing or able to lend to dealers and hedge funds ... indicating some emerging stress in the market," Richard de Chazal, a macro analyst at William Blair, wrote in a client note.
• The "repo rate" at which banks borrow money from other financial firms overnight has been spiking in recent weeks, a sign that money in the financial system is tight.
• Another sign: Banks have been relying more regularly on an emergency Fed facility to secure funding — as much as $15 billion over two days in mid-October, though usage has slowed since then.
• It comes as the Treasury issues more short-term debt to fund the government, a dynamic that soaks up even more cash in the system.

What they're saying: Fed chair Jerome Powell said the central bank long planned to stop shrinking its balance sheet before money gets too tight.

• "We may approach that point in coming months, and we are closely monitoring a wide range of indicators to inform this decision," Powell said in a speech this month.

• But it's difficult to judge when that's the case until there are issues. "Some signs have begun to emerge that liquidity conditions are gradually tightening," he added, pointing to volatile short-term funding rates.

Yes, but: That volatility is nothing like what happened in 2019 — chaos that forced the Fed to abruptly halt quantitative tightening.

• But officials are cautious now because they don't want to risk a repeat of an embarrassing episode in which the Fed seemed to lose control of key rates.

What to watch: Treasury Secretary Scott Bessent is said to be grilling Fed chair candidates over this issue, signaling Powell's successor might be more in step with the White House's thinking about the balance sheet policy.

• The Fed expanded its balance sheet as a stimulative tool in the 2010s and early 2020s, when interest rates were already at rock-bottom levels.

"[T]he Fed's foray into the Treasury markets has drawn it into the realm of public debt management, a role traditionally overseen by the Treasury Department," Bessent wrote in a recent 6,000-word essay.

• "It's not 'Do we have a smaller balance sheet?' It's 'How did we get such a large balance sheet [in the first place]?'" Bessent told a roundtable of reporters earlier this month.